Monthly Update August 2013
Home Capital Group (tsx:HCG)
About the Company: Home Capital is a mortgage lender, primarily in Ontario. They specialize in lending to individuals that can’t get a mortgage through the banks – not because they’re not credit-worthy (i.e. more risky), but because they don’t fit the banks’ lending mold (immigrants with no credit & self-employed where proof of income is sometimes hard to piece together). This allows Home Capital to charge higher rates on their loans and earn industry leading returns.
Investment Thesis: We think the frequent commentary on a real estate bubble in Canada is creating an opportunity to buy a top tier lender at a very compelling valuation. While weak commodity prices are certainly a threat to Canada’s economy and housing market, we see numerous cushions that would protect investors even if housing prices turn lower. Specifically, the balance sheet is protected through: 1) a conservative loan to value ratio (68%), which means that, on average, Home Capital is lending only 68% of the value of the home; 2) conservative appraisals; 3) avoiding rural areas, where the market is more illiquid; 4) little exposure to condos; 5) robust capital ratios. A second layer of protection is provided through the valuation, which we discuss below. In terms of earnings risk, we note that a big driver is the total amount of mortgage debt Canadians have outstanding, and that, since 1970, this number has only decreased in one year, and that was by less than 2%. Additionally, given HCG’s less-automated lending process, we see them being able to take market share from the banks as lending requirements change.
Valuation: HCG has traded up substantially since we purchased the shares at 9x 2012 earnings. We still believe the valuation is compelling at 9x current year earnings. Given HCG’s ROE of 25%+ over the last decade, we believe a multiple of 12x is very reasonable. This implies a return of 33% on multiple expansion alone.
Expectations: While the stock may certainly be bumpy, depending on the path housing prices ultimately take, we believe that investors are protected through the housing cycle.
- Fear of a crash in Canadian housing prices is creating an opportunity.
- HCG has several cushions to proctect investors even if housing prices fall.
- Valuation is compelling at 9x earnings given 25%+ return on equity over the last decade.
Parkland Fuels (tsx:PKI)
About the Company: Parkland is the largest independent fuel distributor in Canada. It operates gas stations, mainly in rural areas across Canada and also has a commercial business (where they bring fuel to businesses and work sites).
Investment Thesis: Parkland is a consolidator in an industry where major oil companies are selling distribution assets and the remaining ownership by independent parties is fragmented. PKI has a goal of growing volumes to 7 billion liters, which would be 10% of the Canadian market. This would increase PKI’s volumes by 75% and double operating earnings. This is very much a scale business, mainly through fuel costs, and so their advantage over competitors increases as they grow. Additionally, the prices Parkland is paying for these assets is attractive and provides substantial earnings and share price growth.
Valuation: PKI trades at 8x EV to 2014 EBITDA. While we don’t expect the multiple to grow beyond that, their growth prospects are robust, especially as they make acquisitions at attractive prices.
Expectations: We expect the company to announce more acquisitions at attractive prices and margin improvement from the aquisition they’ve already made. Combined, these should result in a higher share price.
- Consolidator in scale driven, still fragmented industry.
- Further acquisitions should drive shares higher.
Portfolio Additions (Continued)
CanElson Drilling (tsx:CDI)
About the Company: CanElson provides drilling services to oil and gas companies in Canada, the US and Mexico. It operates one of the deeper and most modern/efficient drilling fleets.
Investment Thesis: CanElson boasts some of the best operating metrics in the business. It’s management team comes from an operational background and they have solid exposure to a number of attractive, oil-weighted energy basins. Additionally, the company is not widely followed by the analyst community.
Valuation: Valuations are very compelling as CanElson trades at under 10x current year earnings and under 8x 2014 earnings.
Expectations: We expect the company to continue to show industry leading metrics and benefit from a pick up in overall industry activity. It is also reasonable to expect the company to pick up coverage by another analyst, which would act as a positive catalyst for the name.
- Management team comes from an operations backgroud.
- CDI has industry-leading performance metrics and exposure to some of the best energy basins.
- Additional analyst coverage and a compelling valuation of 10x earnings should drive shares higher.
We did not delete any positions from the portfolio this month.
We continue to believe that a portfolio weighted towards the US economy will serve investors well. Comments by members of the US Federal Reserve and their mentioning of the word “tapering” have created volatility in recent months. It’s possible that this causes further volatility in coming months, especially as some expect the FED to slow purchases later this year. We view any sell off as a buying opportunity for equities as economic data points in the US and around the world continue to improve. We continue to see the best value in stocks that are more economically tied, and continue to avoid yield plays given significant downside risk in a rising rate environment.
We had a number of companies report earnings this month. Overall, earnings were in line to better than expected. The market as a whole is showing an acceleration in revenue growth, which has been hard to come by the last few quarters. We believe this is one factor moving markets higher. A few highlights:
Celestica – Celestica continues to execute well. Margins are on track to reach target levels and progress on winning diversified clients sounds promising. Return on invested capital and cash generation remain strong.
Tyson Foods – Tyson showed great execution in the quarter with strong chicken sales and margins and continued growth from its pre-packaged, value add business. Lower corn prices are expected to be a great benefit over the next several quarters.
CSX (Rail) – CSX showed strong results in its automotive, chemicals and intermodal business lines. The strength and diversification of this business will become even clearer as the headwinds from coal volumes subside.
General Motors – GM is benefitting from strong sales in North America and China, while making great progress on its European operations.